It takes a lot to convince Dimensional Fund Advisors — a pioneer in investing based on quantifiable characteristics like size and value — to add a new source of return to its investment process.
Now, after years of research, Dimensional is adding a new factor based on the behavior of companies with high levels of investment. But Dimensional will be implementing this factor in its portfolios in a unique way, based on original research that’s expected to be published Tuesday.
“We started looking at the relationship between investment and returns when we implemented the profitability component,” Savina Rizova, the firm’s head of research, said in an interview. “At Dimensional, we do want to vet research very thoroughly before implementing anything. We implemented the size factor in 1981 [when Dimensional was founded], value in the early ’90s, and profitability in 2012 to ’13.”
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In the new paper, Rizova and co-author Namiko Saito looked into the behavior of stocks with high investment — as measured by asset growth — and whether it could be used to improve returns for investors. According to valuation theory, a well-known academic framework for analyzing financial data, a company that needs to pour money into research and development and other initiatives to sustain its profits — so-called “high investment” — should have lower cash flows than a company with similar profits that doesn’t need to invest as much to remain competitive. That means that if both companies are priced the same today, the company with higher investment requirements and lower cash flows will have lower expected returns in the future.
“That is well known,” Rizova said. She and Saito found that this relationship held across multiple markets and sectors.
The crucial finding in Dimensional’s new research was that the negative relationship between investment and average stock returns was really driven by the underperformance of small firms with high investment. The link was found to be weaker with large-cap firms.
Rizova explained that this finding was important for knowing how to actually capture this source of return in practice.
“If you naively say the theory implies a negative relationship, you should see it in large and small stocks,” she said. “Then you can apply it by using underweights and overweights. But we observed in large caps, that it was a weak relationship.”
According to the paper, “one explanation for the weaker evidence is that the dispersion of asset growth among large-cap firms is low relative to that among small-cap firms.”
In its investment process, Dimensional will quantify the investment factor using asset growth as its proxy. Rizova explained that firms can raise capital to invest with equity financing, debt financing, and retained earnings. Asset growth measures a combination of all three. As a result, she said, it made sense to focus on asset growth as a measure of investment and to examine its relationship with expected returns.
Based on its research, Dimensional will exclude small firms with high investment from its portfolios.
“The investment premium is pervasive across markets and persistent over time,” the paper stated. “Moreover, it is present across the relative price and profitability segments as well as across sectors. Considering these empirical findings as well as the tradeoffs among expected returns, costs, and diversification, an efficient way to improve the expected performance of an equity strategy investing in small caps might be to systematically exclude small cap firms with high asset growth.”
